Private Placements, PPMs, & Fund Raising

So what exactly is a private placement memorandum (PPM) and why do I need one?

This article goes over the basic information about what a PPM is, when and why you may need one. This information is being provided as a general overview and a basic education of the common terms and federal securities laws involved with a PPM. Each state has their own securities laws and the discussion in this article is not to be used as legal advice, as each circumstance is different and you should consult with a licensed attorney in your state to be sure that any PPM or offering you do complies with all current laws and regulations.

What is a PPM?

A private placement memorandum is an offering document, sometimes called a prospectus, offering circular, or PPM. The majority of early startups and emerging growth companies commonly raise money through what are know as private placements. It is simply a sale of stock (or debt) in the company to private investors that become shareholders in the company. The reason they are classified as private, is not because they are private investors, but because the offer and sale of stock (a security) does not involve any public advertising or general solicitation of investors. For example, when a stock goes public, they are offering stock publicly by filing a registration statement, press releases, etc. This process of registering the securities with the SEC allows the company to utilize the media and other methods to offer its stock for sale. Since most companies don’t have the money or resources to file a registration statement with the SEC, they rely upon selling the stock through exemptions from registration.
Although there are other exemptions that are used, the most common exemptions used under federal securities laws (Securities Act Section 3(b)) for startups raising money are:

Regulation D– Private offer and sale of securities requiring compliance with manner of offering requirements and limitations on resale of securities requirements. The common categories are listed under the following 3 classes:

Rule 504– raise up to $1 million within 12 month period; no specific information requirements for PPM

Rule 505– raise up to $5 million in a 12 month period; unlimited number of accredited investors and only up to 35 unaccredited investors; 502(b) information disclosures required

Rule 506– unlimited amount of money raised within a 12 month period to accredited investors; unlimited number of accredited investors and up to 35 unaccredited, but “sophisticated” investors; Rule 502(b) information disclosures required

If Rule 505 or 506 placements are only sold to accredited investors, there is no information specifically required to be provided. If there is even one non-accredited investor, the company must provide (unless they are already a reporting company with the SEC) certain financial and non-financial statement information.

Section 4(5)– up to $5 million; unlimited number of only accredited investors

The term accredited investor was amended recently under the Dodd-Frank Act. There are a number of categories to qualify based upon things such as recent income and net worth, but the main change was to limit the definition for net worth to not include the investor’s primary residence as an asset and not include the mortgage on their primary residence as a liability (except for debts taken out within 60 days, for example a cash out refinance).

Rule 502(b) does also required the company to provide reasonable access to information requested by potential purchasers for Rule 505 and 506 offerings prior to their purchase.

Even though a sale may be exempt from registration and have limited or no information requirements to provide to potential investors, the anti-fraud rules still apply and a company can get into a serious bind if they misrepresent, lie, omit, or misstate items about the company, its business, its management, future business, and other items.

Also, as of this article, we are still waiting for further rule-making changes from the SEC for loosening or eliminating the public advertising and general solicitation rules in some cases. This could end up being a help to small companies to give them better access to capital, but we will know more once those rules are finalized.

Those exemptions require that no public advertising or general solicitation is used in the offer and sale of those securities. So, the company is not able to start issuing press releases, posting website ads, or sending mass mailings to potential investors in most cases. This does make it more difficult to get your message out there, but it must be complied with for the offering and sale to qualify for the exemption and not violate securities laws. Often this results in needing to be introduced to prospective investors through connections.

When the company decides to raise money through a private placement (which can also be in the form of a loan, which is still classified as a security), they have certain rules they must follow for the placement to qualify for the exemption and comply with securities laws. Typically, the company was already in the process of, and I highly recommend, putting together things like a 30 second elevator pitch of their company/product/service, a 5 minute presentation, a written executive summary, and a full business plan with financial projections, pro forma data, exhibits, and other relevant materials. The full business plan is essentially the formal document given to potential investors to tell them about the business, its product or services, management, financial projections, and plans for the future.

A recommended list of categories for your business plan (which will also cover many of the PPM information requirements):

Executive Summary– A brief, usually one page or so, overview of what your company does, how it is different or solves an existing problem, who your team is, and what your plans are to grow the business (i.e. how are you going to make money for the investor)

Management Team– Name, title, and a bio on each top member of the management team (officers and directors) to show what experience or assets they are bringing to the table

Product or Service Description– What do you do and how is it novel or better than something else out there and how do you make money from it?

Intellectual Property Protection– How have you or will you protect your company’s ideas, brand name, developments?

Manufacturing and Operations– How will you produce the product or provide the service, as well as manage and operate the administrative side of things?

Human Resources– How many people do you have now and how many do you plan to bring on? Any other challenges, such as using independent contractors versus employees? Do you still need to identify and hire certain positions in the company?

The Market– What market are you targeting and where do you fit into it? What is the landscape and current trends in the market or industry?

Competition– You are probably not the first person to think of this, so how are you better or different than your current or future competitors?

Sales and Marketing– How do you plan to get your message out about your produce or service?

Company Background and Structure– things like current capitalization, how the company was formed, is it a C corporation formed in a certain state…

It becomes essential for the company and management during this process to cover all bases and be sure it is protected from lawsuits and SEC or other regulatory action. When a company fails to execute what they said they would do and the investor loses their investment, the plaintiff’s lawyers start circling looking for someone to go after, like the board of directors and upper management or just about anyone involved with the investment process. This is where a private placement memorandum can be a valuable tool to help protect the company and its officers, directors, and others.

How does a PPM help?

No one can guarantee that the SEC, state regulators, or private investors won’t pursue claims against the company or management, but there are steps you can take to limit any potential exposure. This is where the PPM comes in. The PPM is an offering document that is an expanded form of the business plan that is given to investors. The basis for PPMs go back to the information often required in a full registration statement filed with the SEC. Depending upon the exemption used for the number and level of investors, time for funding, and amount of money raised, there can be differing requirements for what must be provided in the PPM. Even if the exemption doesn’t require some element to be disclosed to investors, it is often a best practice to simply cover all your bases in that document. That is not to say that there may not be a legitimate business reason for not disclosing something when you are not required to do so. For example, in some cases you need to provide a recent audited balance sheet. Many startups don’t have the money to pay auditors to come in and audit their books to obtain the balance sheet, so if there is no requirement to provide that audited balance sheet, it may be best for the company to avoid that additional expense.

The basic principle behind the PPM is to fully inform the investor about all aspects of the business, company, industry, management, prior financial performance, and future prospects, as well as providing certain risk factors involved with investing in a new company, often with no revenue to sustain it. The SEC and state regulators want to be sure that you disclose what is required and don’t over-hype your company. The biggest threat is the anti-fraud statutes. If you put something in the PPM that is materially misstating the facts, misleading, fail to include relevant facts, or an outright lie, you can end up facing serious civil and criminal penalties. As an officer or director, you have certain duties and you have to be sure that you have control over what is happening in the fund raising process. Just as was discussed in Part III, you don’t want a random finder running around selling your stock by saying whatever they need to make the sale and try to get a commission.

How do I get a PPM?

There are services online and companies that offer templates for PPMs, but be cautious in going down that path just because it looks a lot cheaper. If you fail to disclose something you should have and lose your exemption from registration, you could end up in a situation where the invested money is gone, but a regulator is telling you to offer to buy back the stock you sold the investor. Guess who can end up holding the bag if the company is out of business at that point? You.

It is always best to hire a local licensed attorney to assist you in this process. Look for someone with experience in securities laws and private placements. You can save time and money by putting together a good business plan internally, but then having the lawyer add, edit, or clarify the business plan to make it into a full and compliant PPM.

What needs to be in the PPM?

This depends upon the exemption being used for the current offering, but it is best to try to include some general discussion in categories such as: summary information and risk factors, offering terms (e.g. offering for sale of 1,000 shares of common stock at $1 per share), use of proceeds, dilution, plan of distribution, description of securities to be offered, and certain information about the company and its business. This is really a matter for your lawyer to review to be sure you have adequate disclosures. Also, they should review the PPM to be sure that anything that you say in there may not be construed by an investor as misleading or fail to include something material to the business. You want to be sure the document is clear and easily understandable.

Many startups worry about weighing the document down with all that “legal mumbo-jumbo,” but if you are dealing with any investor who has been through the process with a legitimate company, they are familiar with those disclosures. You can see examples of how much risk disclosures are involved by finding a copy of a prospectus for any large publicly traded company. They go on for pages and pages and cover all kinds of random disclosures of possible risks down the road, but they are being cautious to warn investors. The SEC wants to know that investors are being informed and not misled. Most PPMs will include a statement about risks of “forward-looking statements” for things like projected revenues, which is normally a safe harbor from enforcement for public companies, but it is a best practice to include it anyway.

What else needs to be done in the process?

There are other things that are a best practice to in connection with a private placement. You should setup a control log where you document to whom the PPM was given and when. You normally should set definite dates to close the round of funding, be sure to file any required federal or state disclosures, such as a Form D with the SEC or a Form 25102 in California, keep track of when and how much was raised for calculations of exemptions for future rounds, and complete closing checklists. You need to be sure that all your investors got the same version of your PPM, even if they got a shorter business plan. These are all things that companies don’t realize can affect their ability to do business down the road, so it is always best to have a licensed, local attorney assist them with the entire process.